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Lecture 03 P

1. This document contains sample problems and questions related to bond pricing and yields from a university business course. It includes examples of computing bond prices and yields given spot rates, identifying arbitrage opportunities between bond prices, and analyzing the relationship between bond yields and returns. 2. Questions involve pricing bonds with different coupon rates and maturities, constructing bond portfolios to replicate cash flows, and determining the optimal price in a transaction to achieve a profit target. Yield curves, spot rates, and bond prices are given. 3. The document provides practice problems for students to demonstrate their understanding of key bond concepts like pricing, yields, and arbitrage through worked examples.

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173 views3 pages

Lecture 03 P

1. This document contains sample problems and questions related to bond pricing and yields from a university business course. It includes examples of computing bond prices and yields given spot rates, identifying arbitrage opportunities between bond prices, and analyzing the relationship between bond yields and returns. 2. Questions involve pricing bonds with different coupon rates and maturities, constructing bond portfolios to replicate cash flows, and determining the optimal price in a transaction to achieve a profit target. Yield curves, spot rates, and bond prices are given. 3. The document provides practice problems for students to demonstrate their understanding of key bond concepts like pricing, yields, and arbitrage through worked examples.

Uploaded by

alexajung
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Sauder School of Business

Prof. Howard Kung

COMM 371

Problem Set 3

1. Assume that spot rates are as follows:

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Maturity Spot Rate


1 year
5%
2 years
5.5%
3 years
6%
4 years
6.3%

Compute the prices and YTMs of the following bonds:


(a) A zero-coupon bond with 3 years to maturity.

(b) A bond with coupon rate 5% and 2 years to maturity.

(c) A bond with coupon rate 9% and 4 years to maturity.

Assume that spot rates and YTMs are with annual compounding, coupon payments
are annual, and bonds par values are $100.

Th

2. Its lunchtime. You are thinking about this restaurant, Obligation du Tresor, where
you have always wanted to go but never did because you thought it was too pricey.
Luckily, you bump into your friend Jerry, a bond trader. Today Jerry is buying and
selling the following bonds:
Bond Coupon rate (%) Maturity YTM(%)
A
0
1 year
5.00
B
5
2 years
5.85
C
7
2 years
6.25

Coupon payments are annual, and bid-ask spreads are zero.


(a) What are the prices of the above bonds?

(b) Is it possible to construct an arbitrage (and get a free lunch at Obligation du Tresor), given the bond prices? If so, what is the trading strategy that produces the
arbitrage?
Hint: Given the prices of two bonds, determine whether the third bond is overor under-priced.
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3. Which of the following statements are correct?


With todays Yield Curve (term structure of spot rates), you can compute exactly:
(a) The price at which a 5-year T-Strip with $100 face value will trade in two years.
(b) The spot rates that will prevail in two years.
(c) The price at which a 5-year T-Strip with $100 face value trades today.
(d) The price at which a 5-year T-bond with 7% coupon and $100 face value trades
today.

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4. Consider a 10-year bond with annual coupon rate 8%. Suppose that the term structure
is flat at 8%, i.e., spot rates for all maturities are 8%.
(a) What is the bond price and YTM?

(b) Suppose that you buy the bond today and hold it for 10 years. What is your
return (expressed as an annual rate) if the term structure stays flat at 8% for the
whole 10 years during which you hold the bond?
(c) What is your return if the term structure moves down to 6% (still staying flat) 6
months after you buy the bond, and then stays at 6% for the remainder of the 10
years?
(d) What is your return if the term structure moves up to 10% (still staying flat) 6
months after you buy the bond, and then stays at 10% for the remainder of the
10 years?
(e) Comment on the relation between the bonds YTM and the 10-year return on the
bond.

Th

5. (Challenge) You are working for an investment bank. At your disposal, are the following
bonds:
Bond Coupon rate (%) Maturity Price
A
0
7 years $63.39
B
5
7 years $91.81
C
6
6 years $98.17
D
0
4 years $80.18
E
0
3 years $85.48
F
0
2 years $91.48
G
0
1 year
$96.88

Coupon payments are semiannual and par values are $100.


A client approaches you with the following issue. His company will be receiving a $5M
cash flow every 6 months, for the next 7 years, with the first cash flow 6 months from
now. The company will also be experiencing three cash outflows of $16M in 1, 2, and
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3 years from now. The client wants you to structure a deal under which he will be
paying you a fixed amount y every 6 months for the next 7 years (with y not exceeding
the cash inflow of $5M), and you will be paying him $16M in 1, 2, and 3 years from
now. This deal would enable the client to simplify his cash management (since he will
be left with a cash inflow of $5M-y every 6 months).

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(a) After thinking carefully about your clients request, you decide to propose a deal
under which the amount y is equal to $3.9M. Furthermore, you decide to create
and hold a bond portfolio that would replicate the cash flows involved in the deal
with your client. In particular, this portfolio would involve cash inflows of $16M
in 1, 2, and 3 years from now (that you would transfer to your client), and cash
outflows of $3.9M every 6 months for the next 7 years (that you would finance
out of your clients payments). Which of the above bonds, and in what amounts,
should you use to create the portfolio?
(b) What is your profit under the deal?

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(c) What value of y should you chose so that you make an $1M profit?

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